I worked for a Fortune 100 company for over 15 years. When you rise through the ranks of management at a large company, they generally stop talking to you about salary and instead use the work Total Economic Package (or Total Compensation Package). The reason they do this is that you begin to receive something each year called Long Term Incentive Awards. These can come in the form of stock options, performance unites, restricted stock, or incentive type stock options.
Since executives and their families are whisked away today from city to city taking over new divisions and territories, it’s quite possible that someone who works for a Fortune 500 company will get stock options in different states. What most people don’t think about is how these stock options may be taxed, and it can potentially cost you thousands of dollars in back taxes if you don’t do your calculations correctly.
Types Of Stock Options
The three main types of stock options I run into most are Non-Qualified Stock Options, Restricted Stock Plans, and Incentive Stock Options. The main one that I want to review is ‘cashless’ or non-qualified stock options.
Non Qualified Stock Options
A non-qualified stock option is one methodology for a company to compensate key employees or others in an organization without having to actually pay them cash. They work best for employees within a company that has a rising stock price.
The company will grant the employee an option to purchase shares of stock at a fixed price. For example, Coke grants an employee 1,000 options at $65 which are good for 10 years. This means that the employee has the right over the next year no matter how high the stock prices goes to purchase 1,000 shares of Coke stock at $65. So, if Coke’s stock goes to $95, then the option is worth $30 per share or $30,000 to the employee if exercised. All of these types of options will be taxed at ordinary income rates, which is a consideration that needs to be made at the time of exercising the option. When the stock isn’t publicly traded, the company determines the value of a share of stock on the date the option is granted. The options typically lapse on a certain date which is predominately 10 years from the grant date.
The incentive to the employee or service provider is to participate in the potential increase in value of the stock without having to risk a cash investment. The company receives a tax deduction for this ordinary income element reported by the employee or service provider.
The reason these options are called “non-qualified” is they do not qualify for special treatment of another type of option, called “incentive stock options” within the IRS tax code.
What’s The Catch?
The catch is that the state you lived in where the appreciation of the stock option took place will be the state where you owe the taxes. It is NOT the state where you end up EXERCISING the options.
Imagine that in 2005, you lived in the state of California working for a large company who granted you 5,000 shares of non qualified stock options at a strike price of $20 a share. In 2008, you moved to New Jersey and then in 2010 you moved to Georgia. In 2012, the stock price was $50 and you sell all of the stock options producing an ordinary income of $150,000. This is calculated by taking the $30/share growth in the stock price multiplied by the 5,000 shares of stock. From a federal level, you will now have $150,000 of additional ordinary income.
However, the tricky part of the equation is that the appreciation of the stock option price needs to be reviewed to see where the growth of the stock was relative to the state that you lived in at that time. For example, if the stock price grew from $20 a share to $30 a share when you lived in California, then you will need to include $50,000 of that income in a California state tax return even though you haven’t lived in California for years. The same calculation would need to be made for the state of New Jersey and for Georgia as well. The single biggest mistake you can make is to just include all of it as Georgia income. If you do that, you could be subject to huge interest penalties and late fees when the other states figure out that they have lost out on back revenue.
Many people don’t realize how the rules work nor do their accountants spend time to fill them in on these details. It’s possible your former residence states won’t ever figure out what happened, but many states today are hurting for revenue and going to back to get the money they are owed from the past. Be sure that you do the reporting right and you won’t have stock option shock many years later!
Call us for a FREE stock options review at 800.355.9318 or go to www.oxygenfinancial.net
Written by:
CFP®, AAMS®, AWMA®, CRPC®, CMFC®, CRPS®
Editor in Chief of Your Smart Money Moves
Co-CEO and Founder of oXYGen Financial, Inc – The Leaders in Gen X & Y Financial Advice and Services
Ted Jenkin is one of the foremost knowledgeable professionals in giving financial advice to the X and Y Generation.
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